GLD, the New York Stock Exchange-listed gold exchange-traded fund, appears to have quietly removed key investor protection with the apparent agreement of United Kingdom regulators.

By imputation, the same change in regulation applies to the silver ETF SLV, though less obviously so.

A revision to GLD's prospectus appears to have absolved its custodian and trustee from having to comply fully with the custody rules of the U.K. Financial Services Authority, a change that must have been undertaken with the agreement of the FSA and by implication the Bank of England, which oversees the London bullion market and is party to the London Code for Non-investment Products (the NIPS Code). This code now guides the actions of the management, trustees, and custodians of both ETFs.

SLV's prospectus has not been materially altered in this respect (other than by the addition of New York as a custody location) because its wording is already consistent with NIPS Code guidelines. But GLD's prospectus has changed.

I know something about this because some time ago I wrote to the FSA on this very point.

But first let me impart a little background. As an investor in gold and silver ETFs I became aware of the concerns in the bullion investing community in the United States about the apparent lack of investor protection in the GLD and SLV prospectuses, together with the management and custodial agreements to which they refer -- concerns that were heightened by the obvious conflicts of interest between the custodians and other entities within the custodians' own organizations, given that they are also active as principals in both physical and derivative markets.

I am not conversant with legal agreements for such a fund when they are written under U.S. securities law, but I do have experience of similar agreements under English law, particularly where more than one jurisdiction is involved. Their wording appeared to me to be consistent with documentation for offshore funds.

At the risk of oversimplifying, it is standard practice for all the parties to management and custody agreements in an offshore fund structure to absolve themselves of all the risks they can think of and to commit to as little as possible. I presume it is this approach that has caused so much head-scratching for U.S. investors. The reason the English law approach works is because the investors rely on the fact that the parties to the agreement, principally the manager, trustee (if there is one), and the custodian, are all subject to securities regulation by a regulator that has power to inspect them, fine them, and to withdraw their licences to operate. So the FSA’s custody rules become the default guarantee on which investors in these two ETFs rely for the integrity of the assets they beneficially own. Without that guarantee or one of the same rigor, these documents offer little in the way of investor protection.

But there was in my mind one important doubt about the position of the FSA: In the U.K. physical commodities are not a regulated investment, unlike stocks, bonds, mutual funds, and derivatives, and are beyond regulatory scope. So did this give the ETF custodians a loophole allowing them to escape the custody regulations, even though they were holding themselves out to be regulated custodians?

In a letter dated August 22, 2011, I put this to the FSA, which I copy here:

I would be grateful for your clarification of the regulatory position of a regulated entity located in the U.K. providing custody services under a custody agreement for gold or silver bullion.

The question arises because in the case of iShares Silver Trust, JPMorgan Chase Bank N A, London Branch is custodian, and in the case of SPDR Gold Trust, the custodian is HSBC Bank USA, whose address in the prospectus is given as 8 Canada Square, London EC14 5HQ. In both cases, the counterparty to the custody agreements is Bank of New York Mellon. Both of these ETFs are the largest in the world of their type, and according to their prospectuses are fully backed by physical bullion.

The two custodians of these ETFs are also active in the futures markets in the United States (Comex) and it is common knowledge they are running large short positions in those markets. The perceived conflicts of interest have led to widespread public allegations that the assets of these ETFs are being used to satisfy market deliveries in bullion markets that are acutely short of physical, allegations that have not been refuted by the sponsors, trustee, or custodians.

Furthermore, the wording in the prospectuses and the related trustee and custody agreements appears to be somewhat loose without the support of regulatory protection.

I appreciate that it may be difficult for the sponsors to respond to these allegations, which of course is taken as evidence in the markets that they are true. The result is that a false market is being created in both paper and physical markets, either by allegations that are untrue and are not being refuted or by the misappropriation of physical assets not properly under the control of the custodians and without the knowledge of shareholders.

Accordingly, if the FSA does have regulatory exposure to either of the custodians or the trustee, it should be aware of these risks.

I would therefore be grateful for your confirmation that you are fully satisfied that the custodians retain full control over the ETF shareholders' property in accordance with the FSA rules and regulations that apply to authorised custodians. If they are exempt from the FSA’s rules and regulations I would similarly be grateful for an explanation why.

I look forward to your reply.

* * *

I did not get a reply for a considerable time, but after some chasing on my part, I received the following nearly three months later:

* * *

Dear Mr. Macleod:

Thank you for your letter dated 22 August 2011. In your letter you raise the following questions which I summarise below.

Custodians of bullion ETFs, which are apparently fully backed by bullion, are also apparently taking short positions in bullion futures. The concern raised is that the physical bullion backing the ETFs is inappropriately being used to support short futures transactions. Are these firms regulated by the FSA?

I will address the second concern first. HSBC Bank USA London Branch and JP Morgan Chase Bank NA are both authorised in the U.K. and have permissions for safeguarding and administering of assets. The Bank of New York Mellon is also authorised in the U.K. and has permission for the safeguarding and administering of assets. These activities are regulated under Chapter 6, (Custody Rules) of the Client Assets Sourcebook.

The relevant rule here is: CASS 6.4.1 prohibits a firm from using safe custody assets for its own account or the account of another client of the firm, unless:

-- the client has given express prior consent to the use of the safe custody assets on specified terms;

-- and the use of that client’s safe custody assets is restricted to the specified terms to which the client consents.

Regarding your first question we acknowledge your concerns and have passed your letter on to the supervisors of the relevant firms.

Yours sincerely,

Gerard Hurley, Clients Assets PolicyFinancial Services Authority

* * *

Firstly, there is no evidence that "express prior consent" exists, suggesting that CASS 6.4.1 does apply. However, when you look at the actual rule, there are ambiguities about what constitutes safe custody assets. In the FSA Handbook, there are links to definitions that do not include physical commodities, excluding them by implication.

We need to turn to the Clients Assets Sourcebook (Common Platform Provisions) Instrument 2008 (as amended), and on Pages 10 and 11 we find:

"6.1.1A G -- The regulated activity of safeguarding and administering investments covers both the safeguarding and administration of assets (without arranging) and arranging the safeguarding and administration of assets, when those assets are either safe custody investments or custody assets. A safe custody investment is, in summary, a designated investment which a firm receives or holds on behalf of a client. Custody assets include designated investments, and any other assets that the firm holds or may hold in the same portfolio as a designated investment held for or on behalf of the client.

"6.1.1B R -- Firms to which the custody rules apply by virtue of CASS 6.1.1R(1B) must also apply the custody rules to those custody assets which are not safe custody investments in a manner appropriate to the nature and value of those custody assets."

This appears to confirm, as one would expect, that a regulated custodian cannot treat custody assets that are not designated as safe custody assets in a different manner. It is after all unreasonable to expect investors to accept a lower standard of custodianship because of a legal quirk.

Under the Clients Assets Sourcebook, bullion must be treated as if it was a safe custody asset.

In summary, the FSA's reply to my letter confirmed that investors in GLD and SLV were protected by the scope of the FSA's rules, which have the force of law. In other words, so long as the custodians complied with the FSA's Custody Rules, the concerns about the looseness of the prospectus' wording should not be a cause for undue concern in this regard.

Then something interesting happened: GLD re-issued its prospectus.

In GLD's prospectus issued in April 2012, under "Risk Factors" an extra paragraph has been inserted toward the end, as follows:

“The custody operations of the custodian are not subject to specific governmental regulatory supervision.

"The custodian is responsible for the safekeeping of the trust’s gold bullion that the custodian allocates to the trust in connection with the creation of baskets by authorized participants. The custodian also facilitates the transfer of gold in and out of the trust through unallocated gold accounts it maintains for authorized participants and the trust. Although the custodian is a market maker, clearer, and approved weigher under the rules of the LBMA, which sets out good practices for participants in the bullion market, the LBMA is not an official or governmental regulatory body. In addition, while the custodian is subject to general banking regulations by U.S. regulators and is generally regulated in the U.K. by the FSA, such regulatory provisions do not directly cover the custodian’s custody operations in the U.K. Accordingly, the trust is dependent on the custodian to comply with the best practices of the LBMA and to implement satisfactory internal controls for its custody operations in order to keep the trust's gold secure."

This appears to confirm that subsequent to my letter, which the FSA says it passed on to "the supervisors of the relevant firms," investors in GLD are being made aware they do not have the full protection of the FSA as regulator and instead are given the protection of "good practices of the LBMA."

Investor protection afforded for safe custody assets is at least in part being substituted by a dealing and settlement code of practice backed by LBMA-recommended client agreements that applies to an unregulated market.

Put another way, it appears that following my letter GLD's custodian has backed out of its previous arrangement that would enable the FSA to fulfil its mandated responsibilities.

In the case of SLV there are no material changes in this respect between the latest prospectus (November 2012) and the 2010 prospectus. In fact, the wording is pretty much the same for the relevant clause in GLD's (Page 17 of 2010 and Page 18 of 2012):

"London Market Regulation -- Responsibility for the regulation of the major participants in the London bullion market lies with the Financial Services Authority (FSA) under the Financial Services and Markets Act 2000. Under this Act, all U.K.-based banks, together with other investment firms, are subject to a range of requirements including capital adequacy, liquidity, and systems and controls.

"Conduct of business in the London bullion market falls under two jurisdictions dictated by the type of business. The FSA is responsible for 'investment business' as defined under the act. For the bullion market, this covers derivatives. The requirements upon firms in their dealings with market professionals are set out in the FSA's Inter-Professional Chapter, the IPC.

"For spot, forwards, and deposits in silver, which are not covered by the act, guidelines for the conduct of business are set out in The London Code of Conduct for Non-Investment Products, the NIPs code. Market practitioners representing the foreign exchange, money, and bullion markets in conjunction with the Bank of England have drawn up this code. It sets out the standards of conduct and professionalism expected between market practitioners with each other and with their clients, according to the London Bullion Market Association.”

So SLV, in the light of GLD's move from FSA to NIPS Code regulation, has not had to alter its prospectus, a point I missed when I first wrote to the FSA. And so apparently had the FSA -- because the existence of this clause in SLV's prospectus compromised the FSA's responsibilities, which might further explain why it took so long for the FSA to reply to my letter.

This matters because in the case of a breach of the spirit of the FSA rules (and not just the letter), the FSA has the power to require the custodian to remedy it, possibly fine the custodian, and amend the rules accordingly. If instead the FSA accepts that a custodian's actions are governed by a market-driven code, then its powers to protect the beneficial owners of custody assets may be compromised.

In summary, it appears to me that the shifting of regulatory responsibility for custody of client assets from the FSA to the LBMA/BoE NIPS Code weakens the integrity of these two ETFs, supporting the concerns expressed by many Americans in the investing public. The material doubts raised by this uncertainty should in all equity be remedied by the parties to the trust structures.

If it is correct that there has been a material change in regulatory status, they should consider reissuing their prospectuses to address this and other issues that have arisen, bringing them up to date with best practice of other independent ETFs, and should thoroughly address potential conflicts of interest.

To restore public confidence that bullion stocks are not compromised by these conflicts of interest they should consider full independently conducted metal audits to establish and identify the bullion actually held beyond doubt.

For bullion markets this has become extremely important, because both these ETFs are now the largest identifiable depositories of bullion outside government ownership. The redesignation of primary regulator from the FSA to the Bank of England, which has an obvious interest in managing bullion prices, should be an enormous concern for investors.

-----

Alasdair Macleod is an economist and research director for GoldMoney.* * *

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